First Quarter 2016
Market Review & Outlook
Market Summary
Q1 2016 Highlights
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The first quarter of 2016 brought the full cycle of investor emotions. In the first three weeks, the S&P 500 fell nearly 10%, its worse start to a
year on record. After a gradual decline into mid-February, major market indices had retreated nearly 15% from all-time highs set in May of
last year. While this sort of market drawdown is normal in a historical context, this was the largest pullback since the 2011 European crisis
and investor and media sentiment reacted with ripe complacency. Before most opportunities could be scavenged up, equities rallied back to
end the first quarter marginally positive.
The U.S. economy grew at a meager 0.5% annual rate in the first quarter, in line with recent Q1 false starts, but shy of market expectations
and well below long-term average output growth. Energy and manufacturing companies struggled while the U.S. consumer benefited from
low gas prices and early indications of rising wages. Given the relative weight of the U.S. consumer in terms of contributive output to the
economy, the “plow-horse” growth trends of recent years should be able to maintain their relative anemic trajectory.
The U.S. remains in the lingering and pervasive shadow of the Great Recession with consumer de-leveraging restricting growth and Central
Bank leveraging contributing more to asset price inflation (the ‘Wealth Affect’) and less to underlying economic expansion. Consumer leverage
is wonderfully conducive to economic growth and asset price inflation when trending upwards, as we saw leading up to the Great Recession,
but equally as detrimental to progress when stuck in reverse. With household debt service ratios now having declined to levels not seen since
the 1970’s and hints at rising wages, consumer balance sheets are arguably in as good a position as ever to take on new debt. Although
consumers have so far opted to pocket savings, with banks also hesitant and restrictive of new lending, the tailwind of healthy and able spenders
should eventually work its way into economic viability over time.
U.S. Dollar Decline and Oil Rally Triggers Risk Asset Recovery
Whereas the U.S. economy has largely weathered recessionary risk for the time being, Corporate America is undoubtedly fending with a profits
recession. With 62% of S&P 500 companies having reported earnings thus far for Q1 2016, the blended earnings decline is 7.6% year-overyear for the quarter1. That follows 2015’s adjusted earnings decline of 1%. If you are skeptical of earnings “management” by the C-suite of
Corporate America, non-adjusted operating earnings for the S&P 500, which corrects most notably for the “non-recurring” items that
companies often strip out, have declined back to 2012 levels2. Contracting profits and revenue shortfalls have left stock prices in a precarious
position, which has led to the increased volatility over the past year.
The major detractors from earnings over the past 18 months have been the strength in the U.S. Dollar (a headwind for U.S. multinationals) and
the impact of low energy prices on energy companies and their tangential corporate relatives. Since mid-February, the U.S. dollar has sold off
nearly 6% while oil prices have jumped from $26 to $453. Both moves were seen as green shoots for the earnings recovery story and optimism
that recent issues could be transitory rather than secular declines in fundamentals.
On the credit side, dreadful commodity market conditions triggered rising default expectations for high yield bond issuers exiting 2015 and
into the first two months of 2016. At the low point, U.S. High Yield bond spreads widened out to levels not seen since 2011, with energy bonds
showing their highest yield spreads to Treasuries on record4. Once oil prices and other commodities started to recover in price, the spreads
tightened and bond prices rallied to end the quarter. Defaults have increased in the first few months of the year, but the market has now started
to indicate that the fallout could be less than initially expected. Seeing that the energy high-yield default rate has jumped to 13%, well above
the previous record high of 9.7% set in 19995, we remain broadly skeptical of the recent surge in energy bond prices. The real opportunity has
come from the rest of the high yield market that was thrown out with the proverbial bathwater in the risk-off events to start the year.
Defense Becoming Increasingly Expensive
Defensive or “low beta” stocks have been in vogue for some time with the conundrum of low fixed income rates and skittish investors. The
relative performance of these stocks became even more pronounced in the first quarter. We remain long-term believers in the power of
dividends, but the recent surge in popularity of the upper echelon of dividend yielders has created some dislocations in valuations and
potentially some misplaced allocation of “safety” capital. Consumer Staples, Utilities, and Telecom stocks have all outperformed the broader
market by a wide margin year-to-date as investors scooped up the highest yielders and flocked to sectors that historically have held up better
in broad equity market selloffs.
We feel this flock to yield has created opportunities in the under-appreciated dividend growers segment of the market. Patient investors may
be better rewarded with low-and-growing dividend payers priced at more reasonable valuations with above-average prospective cash flow
Feltz WealthPLAN A Registered Investment Advisor and separate entity. - Securities offered through LPL Financial, Member FINRA/SIPC
growth in lieu of higher-yielding stocks with stable cash flow priced at a premium to historical valuation levels and susceptible to headwinds
of rising rates.
On the fixed income side, global Central Bank intervention has suppressed rates to unimaginable levels. Astonishingly, 38% of the developed
world’s supply of government bonds (e.g. Europe, Japan, etc.) were trading at negative yields as of 3/31/166. So while the U.S. 10-year Treasury
yield hovering between 1.5 and 2% might seem unconscionably low, such yield may actually appear relatively attractive to international
investors seeking perceived “safety” in sovereign bonds and willing to take the currency risk. That is also why the long awaited move higher
in U.S. interest rates could remain contingent on the even lower rates of other developed nations moving higher in tandem. Future investors
will look back to the current day and scratch their heads at the appetite for negative yielding investments and the extreme measures of Central
Bank intervention. We remain increasingly dumbfounded and skeptical of the true “defense” being played in these “flight-to-safety”
investments.
Second Longest Bull Market on Record and Investors Remain Skeptical
On April 29, the current bull market in stocks became the second longest on record at 2,608 days, second only to the 1987-2000 bull market
that capped out at 4,494 days. A bull market ends once the index drops more than 20% from its secular high-water mark, and although we
came close to breaching that threshold in 2011 and in February of this year, the trend remains intact.
What is perhaps most remarkable about this bull market run is how few
Americans seem to appreciate or are apt to participate in owning stocks.
According to a recent Gallup Poll, only 52% of Americans have any
sort of investment in stocks, down from 65% in 2007. That is despite
the well over 200% rally in stock prices since the March 2009 bottom
and the S&P 500 trading well above previous highs set before the Great
Recession.
Certainly there are some issues with middle-class economics and
financial difficulties faced by millennials that reduce the ability to own
stocks, but there is more to the story than that. Two 50% corrections in
equities in the span of ten years may have caused an irreparable crisis
of confidence for a good portion of former and prospective investors.
Arguably more puzzling is that in that same Gallup survey, real estate
has surged well past other asset classes as the best rate of return option
over the long-term, according to Americans. Many Americans seem
aware of the poor returns likely ahead for bonds, but Savings/CDs are
given marginally less affinity as stocks for long-term investments with
prevailing savings yields near or just above zero.
Not only are Americans not buying stocks, but they continue to be net
sellers. Since peaking in 2007, Americans have reduced equity
holdings by 18.6%, or over $2 Trillion of total stock investments7. A
similar mass exodus from equities occurred after the Great Depression
in the early 1930’s with investors finally returning over a decade later
enticed only by the high dividend yields of the time.
When looking at the potential sources of return available in capital
markets and the rates of return necessary for most demographic
categories to achieve retirement goals, we still feel strongly that stocks
should continue to offer the best potential to realizing long-term objectives despite the likelihood to also observe the largest intra-year volatility.
We feel that real rates of return over this most important time frame will most principally come from equities, especially given the starting
point for interest rates and the headwinds this presents to fixed income investors. As the saying goes, ‘Bull markets don’t die of old age” and
the longer investor skepticism remains rampant in stocks, the more we believe returns could be adequate for patient and shrewd investors.
Active Management Could Make a Comeback
The last eight years have certainly been challenging for active management. Low volatility and low dispersion in stock price performance in a
surging bull market has been a poor environment for stock pickers and tactical allocators.
Historically, market volatility is highly correlated to active manager performance. For example, in the three-year bear market following the
bursting of the dot-com bubble in April 2000 when volatility was above its long-term average, the market lost an annualized 15.8%. During
this time, the median active manager within the Lipper Multi-Cap universe outperformed the benchmark by an annualized 3.7%8. In terms of
valuation dispersion (the difference in price-earnings ratio for the universe of stocks), higher interest rates have historically been correlated to
higher relative valuation dispersion and, in turn, higher manager “alpha”6. When interest rates drift lower, like they have been over the past
decade, many “boats” rose with the tide due to the relative appeal of equities overall, leaving less opportunity to select stocks to outperform
Feltz WealthPLAN A Registered Investment Advisor and separate entity. - Securities offered through LPL Financial, Member FINRA/SIPC
their benchmarks.
Given the relative underperformance of active strategies, broadly speaking, investors have been apt to move to passive-indexing strategies in
recent years. Last year, passively managed equity funds attracted nearly $200 Billion while actively managed equity funds lost $124B. Passive
US equity strategies now account for more than 40% of total US equity fund assets, up from 18.8% a decade ago. More than a quarter of all
US bond fund assets are now in passive vehicles, up from less than 10% a decade ago9.
As we look out over the next ten years, we feel optimistic that dispersion in valuations and volatility will eventually increase as interest rates
trend higher and the market sequences through different stages of the investment cycle. Given the migration of investors to passive vehicles,
we feel there could be a larger opportunity set for the remaining active managers who still believe markets are, at times, inefficient and that
can potentially preserve and grow capital through strategic asset management.
Over the long-haul, investors should be well served by the average performance brought on by passive exposure to US equities if historical
trends continue, assuming they do not succumb to behavioral tendencies at the worst/best of times. In the near-term, we feel the rapid rise in
stock prices could make near-term gains in equities less-than-average over the next five years given the elevated level of overall valuations
and high-and-contracting profit margins. That just means the low-hanging fruit from this bull market may have been harvested and that further
opportunities to grow could be more arduous. Regardless, we are still positive on the long-term prospects of Corporate America and betting
against such has rarely if ever been a successful strategy.
The headwinds awaiting fixed income investors are arguably the bigger asset allocation challenge, which is why we have continued to broaden
exposure to the Alternative Investments category over the past year as an alternate diversifier for our equity risk. A 30-year bull market in
bonds has created perhaps some false confidence in the “airbag” portion (volatility buffer) of client portfolio allocations, and also the increasing
likelihood of negative real rates of return on that portion of capital. We continue to look for non-correlated sources of return and think outside
the conventional portfolio diversification structure (e.g. Stocks/Bonds/Cash) given the issues in fixed income and our objectives of capital
preservation and growth.
Market timing is a poor investment strategy for the average investor which is why diversification will still be crucial to potentially smoothing
the emotional cycle of being invested in equities. We are increasingly encouraged by the despondency of the average investor and the sentiment
towards timing the next bear market or dismissal of market inefficiencies as it means more opportunities could be right around the corner.
Todd Feltz, CFP®, CFS®
President & CEO
Jack Holmes, CFA®
Chief Investment Officer
Sources:
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9.
http://www.factset.com/websitefiles/PDFs/earningsinsight
http://www.wsj.com/articles/s-p-500-earnings-far-worse-than-advertised-1456344483
http://www.marketwatch.com/story/5-reasons-stocks-are-surprisingly-back-near-record-highs-2016-04-20
http://www.reuters.com/article/us-usa-energy-junk-idUSKCN0US22420160114
http://www.businessinsider.com/energy-high-yield-defaults-at-record-high-2016-5
http://www.valuewalk.com/2016/04/negative-interest-rates-require-flexibility-fixed-income/
http://www.profutures.com/article.php/1009/
http://www.nb.com/documents/public/global/q0074_active_passive.pdf
https://next.ft.com/content/2e975946-fdbf-11e5-b5f5-070dca6d0a0d
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine
which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their
accuracy or completeness cannot be guaranteed.
Statements of forecast and trends are for informational purposes, and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee
of future results. All indices are unmanaged and may not be invested into directly. The Standard & Poor’s 500 index is a capitalization weighted index of 500 stocks designed
to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Stock investing involves risk including loss of principal. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any
given time. Investing in Real Estate involves special risks such as potential illiquidity and may not be suitable for all investors. Investing in mutual funds involves risk,
including possible loss of principal. Value will fluctuate with market conditions and may not achieve its investment objective. The fast price swings in commodities and
currencies will result in significant volatility in an investor’s holdings. CD’s are FDIC insured and offer a fixed rate of return if held to maturity.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in
price. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market
risk. Asset allocation does not ensure a profit or protect against a loss.
Beta measures a portfolio’s volatility to its benchmark. A Beta greater than 1 suggest the portfolio has historically been more volatile than its benchmark. A Beta less than 1
suggests the portfolio has historically been less volatile than its benchmark. Alpha measures the difference between a portfolio’s actual returns and its expected performance,
given its level of risk as measured by Beta. A positive (negative) Alpha indicates the portfolio has performed better (worse) than its Beta would predict.
Feltz WealthPLAN A Registered Investment Advisor and separate entity. - Securities offered through LPL Financial, Member FINRA/SIPC